Retroactive legislation can cause complications when it comes to tax provisions and businesses following ASC 740 for financial statements. Businesses should understand how best to implement retroactive changes and their impact, enactment periods, and disclosures. Here’s what you should know.
When tax legislation is enacted, it’s often done so with retroactive effect. When this happens, businesses preparing income tax returns for earlier years will need to apply the new law as applicable for them. For example, if legislation in 2024 permits deductibility of a particular item for years beginning after Dec. 31, 2022, a business preparing its 2023 tax return in 2024 may be able to deduct that item. However, the financial statement impact of these legislative changes may be reflected in different periods. Therefore, care must be taken to determine both the dates of enactment and effectiveness of new legislative provisions, and GAAP guidance should be followed to ensure these are reflected in the correct financial statements.
ASC 740 and retroactive legislative changes
ASC 740, applicable to business entities preparing financial statements under U.S. GAAP, governs the financial statement presentation of income tax-related balance sheet accounts. This includes payable, receivable, deferred tax assets (DTAs), deferred tax liabilities (DTLs), income tax expense, and disclosures around income taxes. The accounting standard requires that income taxes be accounted for in accordance with the law as enacted on the report date, and it requires that the impact of law changes be taken into account during the period in which the new law is enacted.
A practical application of this standard means that if new tax legislation is enacted in 2024 with retroactive effect to 2023, substantive financial statements dated Dec. 31, 2023, (even if prepared several months later) would ignore the effect of the new law as it didn’t yet exist on December 31, although disclosure of the subsequent change may be required in notes. If the new law creates a permissible deduction for an item that would be reflected on the tax return, the business wouldn’t reflect that deduction in its income tax provision and would instead show it as a permanent or temporary difference (as appropriate for the item), irrespective of what will ultimately be done on the to-be-filed tax return.
As a result, applying this guidance could cause businesses to report, for financial statement purposes, a different amount of current versus deferred tax expense (or possibly a difference in total tax expense) than what will be shown on their actual tax returns.
All other aspects of the income tax provision, including consideration of valuation allowances, uncertain tax positions, and disclosures, should similarly be prepared without regard to subsequently enacted law — even when that law has retroactive effect.
Assessing the financial statement impact of a retroactive legislation change
During the period when the law is enacted, businesses should assess the impact of the changes to their financial statements and record the effects. This period can be the interim or annual period that includes the date on which all steps have been taken to give the legislation the force of law — for federal tax legislation, this means passage by both houses of Congress and signature by the president. For example, if an item of book expense was previously disallowed as a tax return deduction and required to be capitalized, there might have been an increase to current taxes payable and the creation of a DTA. If new legislation retroactively permits that deduction, during the period of enactment the business would decrease its taxes payable for the benefit of the new deduction and simultaneously remove the DTA related to the capitalization. Any changes in judgment related to valuation allowances and uncertain tax positions resulting from legislative changes should also be considered and applied at this time.
Disclosing retroactive tax legislation on financial statements
Although the effects of retroactive tax legislation aren’t taken into account on financial statements for periods prior to the law’s enactment, GAAP may still require a “subsequent event” disclosure in order to help a reader of the financial statements understand that an event that occurred after the year-end but before report issuance may have an impact to the business. When applicable, these disclosures should describe the nature of the subsequent event (in this instance, the nature of the law change) and an estimate of the financial effect anticipated on the financial statements. Even in instances where a subsequent event disclosure isn’t required, many businesses will conclude that it’s beneficial and opt to include.
Taking care when working with retroactive tax legislation and financial statements
There are many considerations when it comes to retroactive legislation and how it could affect a business’s income tax returns or financial statements. Understanding the new legislation, when it applies, and how it should be reflected in different periods on financial statements is important. Add in enactment periods and disclosures, and it’s clear that businesses should take care to fully understand the impact of any new legislation and the timing of any tax changes.
